While households trimmed their holdings of municipal bonds in the fourth quarter of 2012, tax-exempt mutual funds managed to steadily increase their ownership over the same period as investors' need for slightly more risk to offset historically-low interest rates led to a marginal shift in asset allocation.
"Households dipping again, for a second straight year is important, but not alarming, given the likely reasons behind the decline," said Sean Carney, director and municipal strategist at BlackRock. "Rates in 2011 and 2012, were well below where previous purchases were constituted, and as bonds were called away it was difficult to stomach reinvesting at historically-low yields — thus alternative products were likely used within the municipal space," he said.
While households still maintained their coveted tile of being the largest owner of tax-exempt securities, they decreased their direct ownership to $1.67 trillion in the final quarter of 2012 — nearly one third of the $3.71 trillion municipal market, according to year-end data on holders of municipal debt released by the Federal Reserve.
The latest household totals represent a 2.7%, or $46.9 billion, drop from $1.72 trillion that households collectively held in the third quarter, and a 7.4%, or $133 billion, decrease from the $1.81 trillion they owned in the fourth quarter of 2011.
"Rates had come down dramatically during that period and because of that, individuals left the market because they would have had to go out so long to get any semblance of yield," said Howard Mackey, president of the broker-dealer division of Rice Financial Products. "It was an example of the headlines — the equity market had grown at the expense of fixed income," he explained.
But, just because the household sector saw a material decline in holdings at year-end, it didn't mean the retail crowd snubbed its nose at municipal securities altogether; it just shifted its access to the debt, analysts said. Faced not only with historically-low rates, but a record number of bonds being called in 2012, retail investors that were flush with cash opted for an alternative to individual bonds, they noted.
"Reinvestments likely found their way into funds, [exchange-traded funds] and [separately managed accounts] as they offer greater yield, liquidity and diversification as well as certain customization features," Carney pointed out.
Between the third and fourth quarters, investors saw municipal yields dip to 40-year lows on the intermediate and long end of the curve, especially in late November when the 20-bond index of 20-year general obligation yields dipped to 3.29% — the lowest level since Sept. 2, 1965, when it was also 3.29%. On Dec. 31, the benchmark 30-year triple-A GO closed at a 2.83%, according to Municipal Market Data.
The modest decline in household ownership over the period mirrors a trend that surfaced in 2011 as the low-rate environment began to plague the market and kept investors looking for alternative methods of higher income as they pared back their direct holdings of muni debt. Yields were at all-time lows at the end of 2011, and made municipals that year's best performing fixed-rate sector with a 10.7% total return, according to LPL Financial.
By contrast, household ownership peaked at $1.87 trillion in 2010, capping off an eight-year stint of steady increases buoyed by then-higher rates.
Still, mom and pop investors were crucial buyers in the fourth quarter, and are expected to be going forward, analysts said.
"The market continues to be dominated by retail and that is not going away, [but] the product they choose to own, however, may," Carney explained. "The day of direct purchasing has become much more difficult given the loss of monoline insurance [companies] and lack of excess supply in a market that has found itself creating more demand than supply for the greater part of two years now."
The decline in household ownership was offset by increases in mutual fund and bank holdings, noted Craig Thornton, managing director and senior fixed income strategist at Stifel, Nicolaus & Co.
"With mutual funds being a retail investment vehicle, the overall reduction in household exposure to the sector was marginal," he said. "The absolute low rate environment and increased appetite for risk assets in 2012 certainly played a role in the municipal bond allocation shift."
Mutual funds benefited from investors' change in investment pattern, as they ended 2012 with $628 billion in municipal holdings, up 2.9%, or $17.5 billion, from $610.5 billion in the third quarter, and up 16%, or $86.8 billion, from $541.2 billion they held in 2011, according to the Fed data.
As of mid-December, inflows into mutual funds soared by more than $50 billion — sometimes by $1 billion weekly. The flood of inflows was due to a growing willingness by mom and pop investors to seek out higher-yielding alternatives to individual bonds as they also adopted an increasing comfort level with mutual funds following the financial crisis of 2008, experts said.
"Mutual funds offered investors the preferred avenue into this market during 2012, while exhibiting fantastic returns for what has widely become accepted as the second safest asset class only to U.S. Treasuries," Carney said.
The increase in municipal holdings by mutual funds was prompted by a trend that Mackey called "dynamic."
"High-grade munis were trading at higher absolute yields than Treasuries, and that made munis comparatively attractive," he explained. "There was a lot of money going into mutual funds to take advantage of those opportunities."
"You saw inflows and probably part of the increase was a reflection that the financial crisis was abating," Mackey added.
Likewise, bank ownership of municipals rose to $363.1 billion — the highest level in 10 years and an increase of 3.7%, or $13.1 billion — from $350 billion in the third quarter, and a 22.2% increase, or $65.9 billion, from the $297.3 billion they owned in the fourth quarter of 2011.
"With the benign outlook for interest rates, shortening portfolio durations from heightened prepayments on mortgage-backed securities holdings, and a need to limit potential book yield erosion, banks, in aggregate, materially increased their municipal bond holdings in 2012," Stifel's Thornton said.
Money market funds, one of the two other largest holders of municipal debt, ended the year with $336.7 billion — 5.2%, or $16.5 billion, more than the $320.1 billion they owned in third quarter — but their holdings decreased by 5.8% from $357.3 billion held in the end of 2011.
Property and casualty companies experienced modest declines in their portfolios over the period, ending the year with $329 billion in municipal holdings, down 0.3%, or $1.1 billion, from $330.1 billion in the prior quarter, and down 0.6%, or $2 billion, from $331 billion in 2011's last quarter.
Prior to 2008, both categories of holders had enjoyed six years of steady growth in their municipal assets until the financial crisis triggered a four-year decline in municipal holdings.
In other trends, analysts noted that the fairly significant increase in the amount of municipals held by ETFs in the fourth quarter could be an early indication of a lasting and potentially beneficial trend.
Ownership of municipals by ETFs rose to $12.3 billion at the end of 2012 — up 9%, or $1 billion, from $11.3 billion in the third quarter, and up 41.8%, or $3.6 billion, from just $8.6 billion at the end of 2011.
"As they grow and that trend continues, ETFs could represent a very good source of liquidity in the municipal market — which has been elusive for quite some time — and that would enhance the ability to trade bonds," Mackey said.
But Carney was a little more cautious, adding that the growth of assets and acceptance in the ETF market is a trend that needs careful monitoring.
"I think they highlight the amount of passive investment money looking for a home in municipals as well as acting as a 'fast money' tool, allowing strategists like myself the ability to see trends in real time," Carney explained.
But, he added: "They offer access to a market that often takes time, specifically in the retail space, as well as great liquidity at rather tight market spreads."